Unit 3: Monetary Policy Monetary Policy Tools 4/5/2011

federal funds rate federal funds rate – interest rate to borrow from other banks The federal funds rate is the primary target for monetary policy from the Federal Reserve. It is not set directly – rather, it is indirectly manipulated using other policy tools. Federal Funds Rate

basis point basis point – 1/100 of 1% 0.01% = 1 basis point Since 1995 the Federal Reserve has explicitly announced a federal funds rate target at each FOMC meeting. It is commonly reported in the news media as a rise or fall of basis points (e.g., lowered by 25 basis points). Federal Funds Rate

The federal funds rate is targeted by manipulating the supply and demand for bank reserves. Tools to manipulate federal funds rate open market operations discount rate required reserve ratio interest rate paid on reserves Federal Funds Rate

Quantity of Reserves, R RsRs idid i ff * RnRn i er RdRd Supply and Demand for Reserves

definitions R d ≡ demand for reserves R s ≡ supply of reserves i ff ≡ federal funds rate i d ≡ discount rate i er ≡ interest rate paid on reserves DL ≡ discount lending R n ≡ non-borrowed reserves* * reserves not borrowed through discount loans

Federal Funds Rate Quantity of Reserves, R RsRs idid i ff * RnRn i er RdRd Supply and Demand for Reserves

Federal Funds Rate Quantity of Reserves, R RnRn i er RdRd Demand for Reserves

reserves are insurance for deposit outflows the Fed pays interest on reserves opportunity cost is interest forgone o i ff – i er as i ff ↓, the opportunity cost falls o demand more reserves  the demand curve slopes down demand curve perfectly elastic (flat) at i er o if i ff below i er, borrow for certain interest

Demand for Reserves R = RR + ER i ff ↓ → opportunity cost of ER↓ → ER↑  the demand curve slopes down demand curve flat at i er

Federal Funds Rate Quantity of Reserves, R RnRn i er RdRd Demand for Reserves

Federal Funds Rate Quantity of Reserves, R RsRs idid RnRn Supply of Reserves

reserve supply = aggregate reserves of banks two components to reserve supply: o borrowed reserves (from Fed) o non-borrowed reserves cost of borrowing from Fed is discount rate o substitute for borrowing from banks if i ff < i d, won’t borrow from Fed o supply curve perfectly inelastic (vertical) if i ff > i d, won’t borrow from banks o supply curve perfectly elastic (flat) Supply of Reserves

i ff < i d → R = R n supply curve flat at i d

Federal Funds Rate Quantity of Reserves, R RsRs idid RnRn Supply of Reserves

Federal Funds Rate Quantity of Reserves, R RsRs idid i ff * RnRn i er RdRd Supply and Demand for Reserves

market equilibrium is at i ff * supply and demand curves intersect R d = R s at i ff *

Federal Funds Rate Quantity of Reserves, R RsRs idid i ff * RnRn i er RdRd Supply and Demand for Reserves

Ceiling for Federal Funds Rate RsRs RnRn i ff 2 =i d i ff 1 Rd2Rd2 1 2 DL 2 Rightward shift of R d to R d 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2 i er Quantity of Reserves, R Federal Funds Rate Rd1Rd1

Floor for Federal Funds Rate Leftward shift of R d to R d 2 moves equilibrium to point 2 where i 2 ff = i er RsRs RnRn i ff 1 1 Rd1Rd1 i ff 2 = Quantity of Reserves, R Federal Funds Rate Rd2Rd2 i er 2

intersection on downward sloping portion of R d o OM purchase: lowers fed funds rate o OM sale: raises fed funds rate intersection on flat portion of R d o OM purchase: no effect on fed funds rate o OM sale: no effect on fed funds rate Open Market Operations

idid i ff 1 Rn1Rn1 i ff 2 Rn2Rn2 Rs2Rs2 RdRd Rs1Rs1 i er Federal Funds Rate Quantity of Reserves, R Open Market Purchase: Nonborrowed reserves, R n,  and shifts supply curve to right R s 2 : i  to i ff 2 Open Market Operations

idid Rn1Rn1 Rn2Rn2 Rs2Rs2 Federal Funds Rate Quantity of Reserves, R i ff 1 = i ff 2 = RdRd Rs1Rs1 i er Open Market Purchase: Nonborrowed reserves, R n,  and shifts supply curve to right R s 2 : i same at i ff 2 Open Market Operations

Discount Window intersection on flat portion of R s o i d ↓: lowers fed funds rate o i d ↑: raises fed funds rate intersection on vertical portion of R s o i d ↓: no effect on fed funds rate o i d ↑: no effect on fed funds rate

id1id1 i ff 1 Rn1Rn1 RdRd Rs1Rs1 i er Federal Funds Rate Quantity of Reserves, R Rs2Rs2 id2id2 (a) No discount lending: Lower Discount Rate Horizontal section  and supply curve just shortens, i ff stays same Discount Window

i ff 2 = i d 2 Rn1Rn1 RdRd Rs1Rs1 i er Federal Funds Rate Rs2Rs2 (b) Some discount lending: Lower Discount Rate Horizontal section , i ff  to i 2 ff = i 2 d i ff 1 = i d 1 Quantity of Reserves, R Discount Window

Required Reserve Ratio required reserve ratio rises (r↑) o demand for reserves rises o demand curve shifts right required reserve ratio falls (r↓) o demand for reserves falls o demand curve shifts left 1/10

Required Reserve Ratio intersection on downward sloping portion of R d o r↑: raises fed funds rate o r↓: lowers fed funds rate intersection on flat portion of R d o r↑: no effect on fed funds rate o r↓: no effect on fed funds rate 1/10

Required reserve Requirement  Demand for reserves , R d shifts right and i ff  to i ff 2 RsRs idid RnRn i ff 2 i ff 1 Rd2Rd2 1 2 Rd1Rd1 i er Federal Funds Rate Quantity of Reserves, R Required Reserve Ratio

Required reserve Requirement  Demand for reserves , R d shifts right and i ff stays same at i er RsRs idid RnRn Rd2Rd2 1 2 Rd1Rd1 i ff = i er Federal Funds Rate Quantity of Reserves, R Required Reserve Ratio

Float float float – temporary net increase in the total amount of reserves: the Federal Reserve system credits a check to the depositing bank before it debits the withdrawing bank (affects monetary base)

Treasury Deposits treasury deposits treasury deposits – temporary net decrease in the total amount of reserves: U.S. Treasury takes deposits out of banks and deposits them with the Federal Reserve instead (affects monetary base)

Repurchase Agreement repurchase agreement (repo) repurchase agreement (repo) – temporary open market purchase; short term collateralized loan in which a security is exchanged for cash with the agreement that both parties will reverse the transaction on a specific future date at an agreed upon price

Reverse Repo matched sale purchase transaction (reverse repo) (reverse repo) – temporary open market sale Repos and reverse repos typically mature in 1-15 days.

Types dynamic o meant to change MB o permanent: normal purchases & sales defensive o meant to stabilize MB from fluctuations  float  treasury deposits at Fed o temporary: repos & reverse repos Open Market Operations

Advantages Federal Reserve has complete control flexible and precise easily reversed implemented quickly Open Market Operations

Discount Window Types of discount loans primary credit o healthy banks o discount rate (typically 1% above i ff ) secondary credit o banks with severe liquidity problems o typically 0.5% (50 BP) above i d seasonal credit o small banks with seasonal deposits o average of i ff and CD rate

Lender of Last Resort to prevent banking panics o FDIC fund not big enough  1% of deposits o e.g., Continental Illinois to prevent non-bank financial panics o e.g., 1987 stock market crash o e.g., 9/11 terrorist attack creates moral hazard problem

Lender of Last Resort new permanent lending facilities o Term Auction Facility (12/2007) o Term Securities Lending Facility (3/2008) new temporary lending facilities (just for crisis) o Primary Dealer Credit Facility (3/2008) o Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (9/2008) o Money Market Investor Funding Facility (8/2008) o Commercial Paper Funding Facility (8/2008)

Lender of Last Resort term auction facility term auction facility – discount loans via competitive auctions (less stigma for borrowing banks relative to normal discount window) term securities lending facility term securities lending facility – lend treasury securities to primary dealers for terms longer than overnight (to supply more securities for collateral)

Lender of Last Resort Temporary lending facilities were implemented under a loophole. §13(3) of Federal Reserve Act allows Fed to lend money to any individual, partnership or corporation, under “unusual and exigent circumstances” as long as certain requirements are met. This pushed the limit of Fed power.

Discount Window performs lender of last resort function puts a ceiling on the federal funds rate borrowing decision left to member banks

Required Reserve Ratio 1/10 same for all depository institutions o Depository Institutions Deregulation and Monetary Control Act of 1980 requirement (checkable deposits) o 3% of 1st $48.3 million o 10% of any over $48.3 million  FOMC can vary  between 8% and 14%

Required Reserve Ratio 1/10 Disadvantages no longer binding o most banks hold excess reserves can cause liquidity problems increases uncertainty for banks

Interest Paid on Reserves since October 2008 o much longer in Europe, etc. current rate is 0.25% advantages o reduces effective tax on deposits o puts a floor on federal funds rate o less fluctuations in excess reserves o less sterilization needed  can expand balance sheet more

European Central Bank Tools open market operations o main refinancing operations  similar to repos o longer-term refinancing operations  similar to outright purchases/sales lending to banks o marginal lending rate (1% above) o deposit facility (1% below) reserve requirements o 2% ratio, interest paid on reserves

Money Multiplier m = (1 + c)/(r + e + c) M = mMB M ≡ money supply MB ≡ monetary base m ≡ money multiplier r ≡ required reserve ratio c ≡ ratio of currency to deposits e ≡ ratio of excess reserves to deposits

Monetary Aggregates Money supply MB – monetary base (total currency) M1 – very liquid assets M2 – somewhat liquid assets M3 – even less liquid assets MZM – money with zero maturity

Monetary Aggregates Money supply MB = currency in circulation + reserves in bank vaults + reserves with the Fed M1 = currency in circulation + travelers checks + demand deposits + other checkable deposits M2 = M1 + time deposits (<$100k) + savings deposits + MMMF shares (individuals)

Monetary Aggregates Money supply MB = C + R M1 = C + D M2 = C + D + STSV + MMMF STSV ≡ time deposits (<$100k) + savings deposits MMMF ≡ MMMF shares (individuals)

M1 = C + D M2 = C + D + STSV + MMMF s ≡ STSV/D f ≡ MMMF/D m1 = (1 + c)D = (1 + c)/(c + r + e) m2 = (1 + c + s + f)D = (1 + c + s + f)/(c + r + e) M1 = m1MB = [(1 + c)/(c + r + e)]MB M2 = m2MB = [(1 + c + s + f)/(c + r + e)]MB Money Multiplier

m1 = (1 + c)/(r + e + c) M1 = m1MB M1 ≡ money supply MB ≡ monetary base m1 ≡ money multiplier r ≡ required reserve ratio c ≡ ratio of currency to deposits e ≡ ratio of excess reserves to deposits

Money Multiplier M2 = m2MB M2 ≡ money supply m2 ≡ money multiplier r ≡ required reserve ratio c ≡ ratio of currency to deposits e ≡ ratio of excess reserves to deposits s ≡ ratio of STSV to deposits f ≡ ratio of MMMF to deposits m2 = (1 + c + s + f)/(r + e + c)